Public Information Notice No. 08/07

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Colombia

January 28, 2008

On January 16, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Colombia.¹

Background

Colombia's economic performance in recent years has been strong, aided by sound economic policies. The combination of wide-ranging structural reforms and prudent macroeconomic policy management has contributed to increased private investment, higher economic growth, and lower inflation. At the same time, both the public finances and the financial system have been strengthened.

The rapid economic growth of recent years, however, has led to a rise in inflation and a widening of the external current account deficit. Economic growth in 2005-06 exceeded the Latin American average and, at close to 7 percent in 2006 and the first half of 2007, equaled its fastest pace since the late 1970s. Growth is projected at 6¾ percent for the year as a whole. Driven by excess demand pressures and a surge in food prices, inflation rose in 2007 and closed the year at 5.7 percent, above the official target of 3½-4½ percent. The current account deficit is projected to double to 4 percent of GDP in 2007, reflecting rapid import growth.

The authorities have been tightening monetary policy, with the aim of reducing inflation. Since April 2006, the Banco de la República has raised its policy interest rate by 350 basis points to 9½ percent. Combined with the introduction of an unremunerated reserve requirement on new deposits in May 2007, this has led to a substantial increase in lending rates and reduced the rate of credit growth, although the latter remains high.

The peso has appreciated over the last year, driven by strong capital inflows, especially foreign direct investment. The nominal exchange rate vis-à-vis the U.S. dollar and the real effective rate appreciated sharply in the first half of 2007. The authorities attempted to alleviate these pressures through sterilized intervention in the foreign exchange market and later through capital controls. The Banco de la República stopped intervening in May, as continued intervention would have compromised achieving its inflation objectives. The capital controls remain in place, however, although they were relaxed somewhat in mid-December.

Fiscal policy was broadly neutral in 2007. The combined public sector deficit is expected to remain roughly unchanged at ¾ percentage point of GDP, with strong increases in revenues offsetting a rise in investment expenditures. The public debt ratio is expected to fall by almost 5 percentage points of GDP to 38 percent of GDP, reflecting strong economic growth.

Aided by its flexible exchange rate regime, Colombia has weathered well the recent turbulence in global markets. Equity prices and spreads have moved broadly in line with the rest of the region, and there have been no disruptions to debt markets.

Colombia's financial sector indicators remain strong. Despite rapid credit growth, credit-to-GDP ratios are below their peak in the late 1990s and close to the emerging market average. Liquidity has declined, but remains sufficient to cover short-term maturity mismatches. Nonperforming loans remain a small share of total credit.

Executive Board Assessment

The Executive Directors commended the Colombian authorities for their implementation of significant economic reforms and prudent macroeconomic policies, which, in the context of a favorable global environment, have increased private investment, strengthened economic growth and reduced unemployment, lowered inflation, reduced the public debt ratio, and increased international reserves.

Directors shared the authorities' concern that the rapid economic growth of 2006-07 has led to overheating pressures, with inflation exceeding the 2007 end-year target and the external current account deficit rising. Key policy challenges facing the authorities are to achieve sustainable economic growth with price stability through an appropriate macroeconomic policy mix, while further enhancing productivity through the ongoing structural reforms. In this context, Directors endorsed the authorities' tightening of the monetary policy stance, and welcomed the strengthening of the fiscal position and the authorities' commitment to long-term fiscal sustainability. Given the prospect of an expansionary fiscal stance in 2008, many Directors urged the authorities to stand ready to tighten fiscal policy to help reduce excess demand pressures. Some Directors considered that further fiscal steps should await an assessment of the impact on domestic demand of the recent monetary policy tightening.

Directors noted that the current inflation targeting framework has served Colombia well, and generally agreed that it would be premature at this juncture to adapt the framework by moving to a longer-term inflation target on a rolling basis. They agreed that the flexible exchange rate regime is consistent with external stability. They noted that the value of the peso remains consistent with fundamentals, with the recent real appreciation of the peso being driven largely by increased confidence and stronger economic fundamentals. Most Directors stressed that continued flexibility of the exchange rate is important to underpin the inflation targeting framework and allow the economy to respond rapidly to changes in external conditions, while some Directors saw merit in the automatic intervention rule aimed at controlling exchange rate volatility. They viewed the rising current account deficit as reflecting the cyclical phase of the economy. Directors welcomed the relaxation of capital controls in late 2007, and endorsed the authorities' view that capital controls are ineffective in the long run. A number of Directors emphasized the importance of phasing out capital controls, while some others supported them as a short-term measure.

Directors welcomed the continued progress on structural fiscal reform, including tax reform, intergovernmental transfers, and the commercialization of the state oil company. Many Directors saw merit in continued reporting on the state oil company's operations in budget documents, and a few Directors suggested that the authorities also publish a measure of the fiscal balance that includes this enterprise. Directors urged careful administration of the recent decree on special tax zones to minimize negative revenue effects. They also encouraged the authorities to deepen the agenda of fiscal reform. On the revenue side, Directors emphasized the importance of a comprehensive tax reform, including a reduction of the number of value added tax rates and tax exemptions, and encouraged the authorities to build the necessary political support for such a reform. On the expenditure side, there is scope for steps to reduce revenue earmarking and other budget rigidities. Some Directors encouraged the authorities to move forward with the privatization of two national electricity companies.

Directors welcomed the finding that the banking sector remains well capitalized, with a low level of non-performing loans and a high level of loan loss provisioning. They urged continued vigilance in view of the increase in nonperforming loans for consumer credit. In this regard, they commended the ongoing efforts to further strengthen the financial system, including the introduction of counter-cyclical provisioning in the banking system, reinforcement of risk-based supervision, improvement of the regulatory framework for the supervision of derivatives markets, and further liberalization of the insurance sector. They also emphasized the importance of increasing the independence of the Financial Superintendent.

A few Directors encouraged the authorities to remove the exchange restriction arising from the special regime for the hydrocarbons sector.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.